It is a natural extension of ATI Capital Group, Inc.'s ("ATICG") corporate practice to have our services encompass the needs of the owners and founders of the business entities we serve. To that end, Corporate Transition Strategies and Income & Estate Tax planning are inexplicably linked.
Business Transfer Channels
For the privately held business owner, the first and most important step of a successful financial plan\retirement plan\estate plan is determining how you are going to transfer the ownership of the privately held business. It is clearly the largest component of any financial plan and it impacts all decisions going forward. The following exhibit was taken from Robert Slee's book, Private Capital Markets - Valuation, Capitalization, and Transfer of Private Business Interests, which shows the many transfer channels that a business owner can choose from when transfering the ownership of the Company from one generation to the next. What is important to understand, as articulated in Private Capital Markets, is that the transfer motives choose the transfer channel, which determines the rules as to how business value is measured.
Much of complex income and estate tax planning used in today's business environment involves "corporate transition planning". When the decision is made to transfer the company through an "internal transfer process", many of the techniques used are designed to also minimize the gift and estate taxes. The problem with estate tax planning techniques for a privately held business is two-fold, first there is no assessment of the techniques impact to the Company's cash flow relative to its value as required under Revenue Ruling 59-60, and second, there is little consideration as to whether the strategy provides the seller the cash flow necessary to allow him\her to retire in a manner commensurate with their expectation. This problem generally does not exist when income & estate tax planning for an individual that does not own a privately held business. Therefore, when income & estate tax planning for a privately held business owner is undertaken via an internal transfer as illustrated above, "Combination Planning" must take place. Combination planning is nothing more than using two or more accepted estate and\or income tax planning tools to give the business owner a desired result. Furthermore, when dealing with a privately held business, we may have to implement multiple strategies for the business along with multiple strategies for the business owner personally. Lastly, if the estate tax plan implemented does not give consideration to the fact that the Company has limited access to capital, the children, management team taking over, or the trusted V.P. may not be able to take advantage of business opportunities that can grow the value of the Company.
Combination Business & Personal Strategies:
The most often use of "Combination Planning" consists of using multiple estate tax planning tools for the business and using them as part of the overall personal retirement and estate tax planning of the business owner. Here is one such example:
Dynasty Trust Combined With an "Equity ReCap" of "S" Corporation Stock:
Here’s how it works. Companies that are taxed as an “S” corporation generally have very few estate planning options. One such option is called a Qualified Subchapter S Trust ("QSST"), this trust is an allowable owner of “S” Corporation stock. A Dynasty Trust is a form of a QSST that can be created in some states, and it has substantial “combination” benefits. The trust is funded with a reasonable amount of cash and a Generation Skipping Tax ("GST") election is made at the time of creation. Prior to the purchase of stock by the trust, the Company is re-capitalized into two classes of stock, voting and non-voting, as allowable under sub chapter "S" of the Internal Revenue Code ("IRC"). The Trust then purchases some, most, or all of the non-voting “S” stock from the shareholder in exchange for cash and a note. The taxpayer makes the “installment sale election” and thereby reports capital gain and interest income on the sale as payments are received. Distributions are made from the “S” Corporation, which are in turn used by the trust to make the payments on the note. The “S” Corporation also distributes enough money to the trust, and from the trust, to the beneficiaries to pay their pro-rata share of the income tax due via the QSST “flow through.” Keep in mind that the trust could also be an Intentionally Defective Grantor Trust ("IDGT"), under that scenario, the seller would be responsible for the tax on the income reported via the form K-1. Once the note is paid in full, the money in excess of the income tax liability via“S” Corporation distributions, can be distributed to beneficiaries or remain in the trust and invested. Keep in mind that if the Trust is an IDGT, distributions will go to the beneficiaries while the grantor will still be responsible for the K-! tax liability. If the Corporate By-laws only allow for employees, officers, directors, and the trust to be shareholders, then the children working in the business can receive stock and those that are not working in the business can receive cash from the trust. In summary look at what has been accomplished:
- We have removed all the value of the stock plus future appreciation in the private company from the estate.
- We have diversified the "legacy's" estate.
- Non-dividend distributions have no tax consequence to the seller of the stock, but are used to pay the note at capital gain tax rates to the seller. Interest on the note is taxable as such.
- We have removed or reduced the FICA tax liability from the seller and the Company; he/she has retired or is semi-retired.
- We have “Generation Skipped” the entire value of the stock because the stock is purchased by the trust for full and adequate consideration.
- We have not used any annual or lifetime gifting exemptions. In fact, at this point a gift tax return is not filed.
- A vehicle for "estate equalization" has taken place for all children.
- The “Fair Market Value” of the note enjoys valuation discounts.
- We have further"asset protected" the Company from the claims of personal creditors.
This has the affect of removing the stock from the estate for “full and adequate” consideration at today’s value. The trust provides asset protection from the claims of creditors and it gives the business owner the ability to convert ordinary income to capital gain income, while giving the family the ability to spread the “S” corporate income tax liability over all the beneficiaries’ tax bracket (with limitations for minor children). It allows the “legacy” to continue to work and earn a salary in the Company even though they no longer own 100% of the stock. Last but not least, future stock appreciation is now out of the estate of the seller and allowing the estate to legally skip a “generation” for amounts far in excess of the allowable GST exemption.
As we can see, this type of planning requires a team of professionals and is generally beyond the scope of the business or personal CPA. The estate tax attorney, the corporate attorney, the CPA, the financial planner and the valuation professional must work together to meet the family's needs, without usurping the cash flow that can bankrupt the Company.
Combination Business Strategies:
As discussed under Multi-Stage ESOP planning, every business has three groups of individuals that must be motivated to improve the revenue and profits of the Company; the current owner, the management team taking over, and the employees. As we have seen throughout our ESOP discussion, multiple strategies must be employed to motivate all three groups. The following is an example of a Combination Corporate Transition Strategy which, if implemented, will create substantial results for the seller of stock, the management team, and the employees of the Company.
ESOP and Executive Compensation Plan:
As we have seen, the ESOP is a powerful tool in assisting in the transfer of stock from one generation ownership to the next. The thing to remember is that ESOPs are qualified plans, and all employees participate in the plan with stock allocations that are based on qualified payroll. The result is that the ESOP is very good at motivating the selling shareholder through tax advantages to the seller and Company, while providing a retirement benefit that accrues to the employees. What ESOP's are not very good at is motivating and rewarding management for shouldering the responsibility of taking on the day-to-day operations. To that end, we can combine the ESOP with Cash based incentive plans and Non-Qualified Stock Option plans that accrue a benefit to the management team for performance in excess of the industry average. Our executive compensation experience allows us to develop multiple plans that will motivate each member of management for taking on the additional responsibility associated with "running an ESOP Company". The plan must not only meet the the trustee's approval, it must be in compliance with IRC §162(a)(1), and its effects must be taken into consideration by the independent valuator. It is for this and other reasons that the professionals setting up the plan not only be knowledgeable in areas of deferred compensation, they must have a deep understanding of ESOPs, executive compensation limits under IRC §162(a)(1) as well as, understanding the impact this planning will have a the ESOP repurchase obligation. With the guidance and consultations of ATICG the goal is accomplished and all three groups are motivated to increase revenue and profit. The end result is that the value of the stock is going to increase insuring the success of the plan. What is important to realize is that in our discussion, we have not addressed the many important personal issues of the selling shareholder such as, "estate equalization" among the children in the business vs. those that are not; the charitable intent of the selling shareholder as well as a whole host of other issues that may present themselves based on the facts and circumstances of the selling shareholder. To that end, combination planning will require an element of personal planning. This may be accomplished, for example, by combining an ESOP with a Family Limited Partnership, a Charitable Remainder Trust, or a Dynasty Trust. Other options include combining a Leveraged Buy-out ("LBO") with the same type of "trust" planning described above, or by combining other sophisticated personal planning techniques with an internal or external equity recapitalization.